Spain downgrade adds pressure, Merkel & Sarkozy to talk

A double-notch downgrade of Spain's credit rating has piled pressure on European leaders to make convincing progress on solving the region's debt crisis at an October 23 summit.

The blow from Moody's Investors Service came just a day after the agency warned France its triple-A rating could come under pressure and as Greeks began their biggest strike in years in protest at a painful austerity drive designed to avert default.

Markets are counting down to a summit of EU leaders on Sunday which Paris has said will deliver a decisive outcome while Berlin has been more cautious.

The Spanish rating cut, which highlighted the threat of contagion from debt-stricken Greece, tempered a sharp rally in shares on Wall Street late on Tuesday.

German Chancellor Angela Merkel warned that leaders would not solve the debt crisis at a single meeting.

"These sovereign debts have been built up over decades and therefore one cannot resolve them with one summit but it will take difficult, long-term work. Nonetheless, I do think we will also be able to take relevant, important decisions," she said.

A French government spokeswoman said Merkel and French President Nicolas Sarkozy, the leaders of Europe's two biggest economies, would talk later on Wednesday.

"It's obvious that the contacts between Germany and France will be constant and permanent until October 23," said Valerie Pecresse, who is also France's budget minister.

The hope is that Sunday's summit will agree new steps to reduce Greece's debt, strengthen the capital of banks with exposure to troubled euro zone sovereigns and leverage the euro zone's rescue fund to prevent contagion to bigger economies.

Scotching a media report that said a deal had been struck between Paris and Berlin to scale up the European Financial Stability Facility by around 5 times to more than 2 trillion euros, a senior EU official said: "It's wrong."

A second source said: "It's naive to think you can make those calculations and come up with a nice round 2 trillion figure. It's not nearly as simple as that."

The summit is likely to agree to leverage the bailout fund by allowing it to underwrite a portion of newly issued euro zone debt, officials have told Reuters. But the details are still being thrashed out.

"I think the models to make the EFSF more flexible need ... significantly more preparation," Austrian Finance Minister Maria Fekter said.

By guaranteeing the first 20-30 percent of any losses, the EFSF could stretch three to five times further. With about 300 billion euros of its 440 billion-euro capacity still available, the fund could be expanded to more than 1 trillion euros, enough to support the refinancing needs of Spain and Italy for at least the next year or longer and ward off market attacks.

As well as trying to strengthen the rescue fund, euro zone leaders are racing to convince banks to accept "voluntary" writedowns of up to 50 percent on their Greek sovereign holdings and are trying to agree on a blueprint for recapitalizing financial institutions at risk from the deepening crisis.

Greece remains mired in recession and its overall debt is forecast to climb to 357 billion euros ($489 billion) this year, or 162 percent of annual economic output -- which few economists believe can be paid back.

Even the mighty German economy is not immune. Government sources told Reuters that Berlin would slash its 2012 growth forecast from 1.8 percent down to around one percent, with the debt crisis hitting German export markets and dampening consumer spending at home.


Moody's cut Spain's bond rating to A1, from Aa2, the third of the major agencies to act in recent weeks and taking it a notch below the ratings of Standard & Poor's and Fitch.

"Since placing the ratings under review in late July 2011, no credible resolution of the current sovereign debt crisis has emerged and it will in any event take time for confidence in the area's political cohesion and growth prospects to be fully restored," the agency said.

In a statement, Spain's Treasury said the downgrade reflected a short-term reaction to negative euro zone debt markets, rather than a change in medium and long term economic fundamentals, adding that the government remained committed to fiscal consolidation and reform.

While Europe's leaders rush to stop a larger writedown of Greek debt infecting others in the euro zone, for ordinary Greeks, the cuts demanded of their country in return for help means facing up to years of pain.

Greek unions began a 48-hour general strike, the biggest protest in years, as parliament prepares to vote on sweeping new austerity measures designed to stave off default.

The strike shut government departments, businesses, public services and even providers of everyday staples like shops and bakeries and will culminate in mass demonstrations outside parliament.

The austerity package mixes deep cuts to public sector pay and pensions, tax hikes, a suspension of sectoral pay accords and an end to the constitutional taboo against laying off civil servants.

A first vote, on the government's overall bill, will be held on Wednesday night, with a second vote on specific articles expected some time on Thursday. It is expected to pass even though Greece has sunk deeper into crisis, despite repeated doses of austerity.

"None of my colleagues, who have been through a lot lately, will risk letting the country fall from our hands and break, go bankrupt," Development Minister Mihalis Chrysohoidis said.

($1 = 0.731 Euros)

(Additional reporting by Lefteris Papadimas and Renee Maltezou in Athens and Michael Shields in Vienna; Writing by Mike Peacock, editing by Janet McBride)